The collapse of the lesser-known Silicon Valley Bank (SVB) on March 10 triggered a sell-off in banking stocks across the markets bringing back the dark memories of contagion following the collapse of Lehman Brothers.
Though the US treasury stepped in swiftly to check a run on the bank and ensure the markets and depositors, one question remains. Did we not learn anything from the Lehman collapse that triggered the financial crisis in 2008?
Back in its heyday, Lehman Brothers was the fourth-largest investment bank in the US. The 150-year-old institution had about 25,000 employees on its rolls spread across the world.
Lehman Brothers invested heavily in mortgage-backed securities, especially subprime mortgages, which are loans with higher interest rates given to borrowers with poor credit histories. Though these investments involved high risk, Lehman Brothers believed them to yield higher returns amid a boom in the housing market.
Lehman ignored the early stages of the housing market crash in 2006 and invested heavily in subprime loans and became the largest holder of mortgage-backed securities by 2007.
So when many borrowers defaulted on their mortgages, leading to the housing market crash, Lehman suffered huge losses. The bank also used borrowed money to amplify potential profits without considering the immense losses it could incur if the investments failed to perform. This aggressive leverage policy and global financial instability contributed to its collapse.
The Lehman Brothers collapse taught us the importance of risk management, the dangers of excessive leverage and the need for transparency, accountability and effective regulation.
Though much smaller compared to Lehman Brothers, Silicon Valley Bank (at the time of bankruptcy, SVB was the 16th largest bank in the US) also had invested heavily in mortgage-backed securities. SVB's high deposit rates attracted customers from its competitors. The bank chose to invest in mortgage-backed securities due to their steady returns. This normally harmless strategy failed when the Federal Reserve decided to quit its wait-and-watch policy on rising inflation and started to raise key interest rates.
Due to the sudden increase in interest rate, the prices of the usually higher-yielding long-term bonds held by SVB fell. It would have been unaffected if they could hold on to the investments till their maturity. Contrary to their expectations, most start-ups that had deposited their money in SVB withdrew the money due to less availability of funding or loans at reasonable rates (start-up winter).
So SVB had to sell the bonds and realize the losses. They sold off a $21 billion bond portfolio in the available-for-sale securities and recognised a loss of $ 1.8 billion. To cover up losses, they tried to raise 2.25 billion from investors in equity and debt, which backfired when the clients withdrew all their money. Thus the SVB stock plummeted by 60 per cent in one day due to a classic run on the bank.
Thus, the ignoring of the warning signs by the SVB management and their toxic positivity that underrated the importance of effective risk management led to its collapse.
SVB collapse might not trigger further collapse even though its collapse was preceded by the failure of Silvergate Bank and succeeded by the Signature Bank debacle. But the collapse highlights that financial institutions are still engaging in risky behaviour and are pushing the limits of regulation.
Thus, continued vigilance and oversight by regulators are essential to prevent such situations from happening. Also, individual investors should understand the risks associated with their investments and make informed decisions based on sound financial principles. They should diversify their portfolios and avoid highly speculative investments that may be subject to sudden and significant price fluctuations. Though high hopes have yielded great losses, let us earnestly hope another event will not be required to remind us of these lessons.